What to expect as US nears ‘unimaginable’ debt default

Officials have warned that the US government is weeks away from running out of cash, raising the possibility that it will default on its bonds if a political battle in Washington over the debt ceiling is not resolved.

Analysts, economists and industry groups expect the White House and Congress, as has happened so many times before, to cut a deal and avoid default.

But Treasury Secretary Janet Yellen has warned that if they don’t, the US may be unable to pay its bills as soon as June 1, a view backed by the Congressional Budget Office, a nonpartisan government agency.

What will the default look like?

The United States will be in default if it does not make scheduled payments to investors who hold government debt, known as Treasury bills. Major holders include foreign central banks, which depend on Treasury bills and the US dollar for their cash reserves.

Then the credit rating of the United States is lowered. The absence of other payments — such as payments for Social Security and Medicare or government and military salaries — would not constitute a default, according to Moody’s and Standard & Poor’s.

Some Republicans in Congress have discussed the possibility of the Treasury Department prioritizing bond payments if default is imminent. But Yellen dismissed that notion, describing debt payments while others were late as “default by another name.”

An analysis from the White House suggests that a short-term default would result in the loss of half a million jobs and a 0.6 percent drop in gross domestic product. A longer default could result in the loss of 8.3 million jobs and a 6.1 percent drop in gross domestic product. Borrowing costs will rise in both scenarios.

Default “would ruin the US government’s credit score. It will take a long time to fix, just as it does with individuals,” said David Kelly, chief global strategist at JPMorgan. Because of this downgrade, “US taxpayers will have to pay More taxes for decades to come.

What payments will the United States have to make?

The United States is liable to make large interest and principal payments on bonds around the so-called “X date” — the day the government runs out of money.

Interest payments on Treasury notes are made on the 15th and last day of each month. The month-end payments for May are expected to be between $10 billion and $16 billion, according to estimates from the Central Bank of Oman. In June, the payment in the middle of the month would be around $3 billion, while the end of the month payment could be between $10 billion and $16 billion.

Investors own roughly $90 billion in Treasury notes due at the end of May, and $138 billion due through June that the Treasury has a responsibility to pay off, TD Securities estimates.

Large payments for domestic obligations, such as Medicare and Social Security, are also due in the coming weeks.

The Central Bank of Oman estimates that the treasury has about $360 billion available for May and early June, until additional quarterly tax payments are made on June 15.

“The first two weeks of June are going to be very shady,” said William Hoagland, vice president of the Center for Bipartisan Policy.

What will happen to the markets if there is a default?

Riskier assets such as US stocks and corporate bonds will face significant losses. US bonds and the dollar are traditional haven assets for investors in periods of volatility, and ironically, their value can rise immediately after a default – even though the default would be on US debt. This is because investors say the willingness and ability of the US to pay its bondholders is not in question after all.

Seema Shah, chief global strategist at Principal Asset Management, said a US default was “inconceivable” as it would “wreak havoc” on global financial markets. Bank of America’s monthly survey of fund managers shows that 29 per cent of managers do not expect any resolution to the impasse, up from 20 per cent in April.

But for holders of insurance on US government bonds, which have soared to record highs recently as fears of default grow, they await a potentially huge payout.

Credit default swaps are contracts between two market participants, one of whom agrees to make a payment if the issuer defaults on its debts. The size of this payment is actually the difference between the original value of the bond and its current market value.

The bond used to determine the payments is usually the cheapest bond in the market issued by the borrower. The difference in price between the cheapest bond on the market and the one for which the insurance was purchased is not always large. But for US defaults, it is, because the sharp rise in interest rates since early 2022 means there are Treasuries trading at a deep discount — less than 60 cents on the dollar.

That could mean a huge return for CDS holders, provided the US does not make a payment on its bonds within the three-day grace period allowed by the International Swaps and Derivatives Association.

For those buying protection via credit swaps, if they’re lucky and… [Washington] Capital screws up,[they]can settle for this really cheap bond that wouldn’t normally be there unless we had this massive increase in interest rates,” said Peter Chirr, head of macro strategy at the Securities Academy. “The yield will be much higher than it was in the past, because of the interest rates.”

What can the Federal Reserve do?

Fed Chairman Jay Powell has been adamant that the central bank is limited in its ability to offset any damage caused by a default, even though officials have in the past limited the ways in which it could act.

For example, in transcripts from deliberations in 2011 and 2013—the other years marked by debt confrontation—the central bank discussed using regular tools such as removing securities from the market overnight and lending cash through buybacks, or even buying Treasury bonds outright. direct.

But this could mean that the Fed should halt its plan to shrink the size of its balance sheet.

Another alternative was for the Federal Reserve to remove distressed Treasury securities from circulation, either by buying the affected securities or swapping those for ones it owns. In 2013, then-governor Powell called the options “abhorrent,” though he admitted that “under certain circumstances” he could consider supporting such solutions.

Additional reporting by Lauren Vidor in Washington and Chris Flood in London

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